Friday, October 27, 2006

How much do I initially have to invest?

How much do I initially have to invest? How much can I afford to consistently add later?

Einstein described compounding as “The Eighth Wonder of the World” and for good reason. Being able to earn interest on your interest allows investments to increase exponentially faster than with simple interest. A one-time investment of $5000 earning 10% interest compounds to a total of over $54,000 after 25 years. Using simple interest, it would take over 95 years to reach the same amount. Naturally, the larger your initial investment and the more you can afford to add later on, the more you can expect to gain in returns.

Am I carrying any high-interest debt, such as on a credit card?

Before saving for future events, you should consider your present finances. Paying off any high-interest loans function as an “automatic” return. Writing a check to Visa to pay down your debt may not feel as satisfying as starting a nest egg, but by eliminating those 22% interest payments, you have effectively “made” a 22% return. Although you need not completely eliminate your debts, getting such payments into a reasonable area should be a more pressing priority.

This fiscal reckoning is also a good time to examine budgeting and expenditures. Look for unneeded or overpriced purchases, and consider the feasibility of paring them down and saving the extra money. Unused gym memberships, that $5 whipped mocha-hazelnut cappuccino, and extra cable channels all add up. The true cost of these and all other purchases involves understanding the “time value of money”, but for now it should suffice to say that $5 added to the previously mentioned investment account compounding 10% for 25 years turns into $54.17.

What is my risk tolerance? What is my investing style?

This question leads us to selecting individual investments. Consider your investment timetable for when you’ll need the money, recognizing that more conservative selections should be made the shorter the window. Everyone’s risk tolerance is different; while one person may feel comfortable with small-cap biotechs another may need a blue chip to feel equally sound.

Analyzing the risk to reward ratio here is a good first step. The more risk you take on, the more you should expect to get in return if your investment pays off. The inverse is also true: the more stable an investment, the less return one should expect. Government-backed I Bonds pay over 6%, but involve tying up money for years in order to fully benefit from them. While this gives you one target, the average return of the broader market indices is about 11% per year. There are two primary schools of thought about investing: growth and value.

Growth

Growth investing is a higher-risk strategy which focuses on finding smaller companies poised to rapidly grow earnings. Stocks here tend to be micro-caps or small-caps, and the occasional mid-cap (under $10 billion). In their younger lives, many of the well-established companies of today found themselves considered here (Think of Apple Computers (AAPL) or Starbucks (SBUX)). Growth companies can be found in many different sectors, although such companies often have similar traits. A growth company usually has a unique product or service to offer which can fundamentally change how business is done. When found early enough in their growth cycles, these companies have the potential to return enormous profits to investors.

Value

Value plays usually are found in larger companies, although the strategies used to find them can be applied to smaller corporations as well. Looking for value stocks is similar to looking for values in a store: find a good product at a price below what you would normally expect to pay. These bargains are often found in the form of companies which have been unfairly beaten down through overselling. Finding value stocks usually involves using a discounted cash flow model (DCF) to find a company’s intrinsic value. This is the form of investing advocated by Benjamin Graham, and popularized by Warren Buffett.

GARP

GARP, or Growth At Reasonable Price, is a combination of the above forms. As the name implies, the focus is finding growing companies trading at reasonable prices. Quick measures of this include the PEG ratio (Price to Earnings to Growth) and Forward P/E. Although not a specific style, GARP is utilized by many investors because of its flexibility. The average, diversified portfolio will have many GARP-type stocks in it.

Getting Started: Learning the Market and Selecting Stocks

If you were going to spend several thousand dollars on a refrigerator or television, you would thoroughly research the market for those goods to find the product which best suited your needs. Investing is no different. Before buying into a company, you should be well-acquainted enough with it to give a short presentation. Knowing the basics of how a company operates, what it sells, how it makes money, how much money it makes, and what kind of growth the company is expected to experience are all crucial questions that any investor should be able to answer. Developing a better understanding of the stock market is a long, but hopefully rewarding, process.

Immediately investing in stocks with real money, however, is equivalent to taking a test without being introduced to the material. Formerly called “paper trading”, beginning investors would normally spend several months tracking their stock picks without having real money on them. Thanks to technology, you can now find sites that automate (for free) the process of tracking price changes for you on the internet. Simulated investing is a risk-free way of beginning to understand market fluctuations and the forces driving them.

Examining these trends will payoff in the future, as an increased understanding of the stock market can only help you on your path to building wealth. Once you become comfortable picking your own stocks, you can still continue to “paper trade” online, as it offers the opportunity to explore and experiment with other investing styles. Gordon Gekko, the famed villain in Wall Street played by Michael Douglas, said “Information is the most valuable commodity I know of”. Ignoring for a moment that the movie ended with indictments for insider trading, the statement is true: you will not regret being an informed and intelligent investor. The market is constantly changing, but by learning the ropes of investing you too can pull off a “One Up on Wall Street”.

Tuesday, October 24, 2006

10 things the new kid on wall street needs to know

10 so you want to play the stocks kid! Well, gather around and let us share 10 things that we have learned to stick this game out for the long haul.

Being a new kid on the block of investing is a lot like being a small fish in a big pond. The new adventure of a big pond can be scary, adventure, and fun. Some keys for the new kid on wall street would be:

1) Learn to make your own decisions.

Everyone will give you advice. Most of it is worthless. You need to make your own investment decisions. It’s your money, and believe me, no one cares if you lose it. In fact, many are rooting for you to, because they want to make money off you.

2) Never blindly trust information.

You need to independently confirm every thing you hear about a stock or a company. Through good solid research yourself. People will lie, because they stand to make a ton of money from stock sales. They’ll gladly mis-represent information, so insist on looking at the real thing, real facts, and real research.

3) Do the work and understand what you’re buying.

Stock investing a fairly complex topic. It could take you many months or even years to master the basics. Mastering the basics is what you need to be concerned with. If you really thing there’s a fast buck coming your way, you need to wise up. One key that we always want to state is always investing thinking long term. Not to many people win short term though it can be done it's done by the experts!


4) Develop a trading style or system.

Don't just make up a system, but research systems, so what others do and continue to do. But, then make some small changes and make your own unique system. Don’t always base all your ideas from other famous people’s systems. In every system has it's strengths and weakness. There is no peferct system to get rich fast. A key is to come up with your own personalized investing methods and systems that work for you, your budget, your personality.

5) Ignore “HOT STOCK TIPS”.

Most hot stock tips are SCAMS!! If they were as hot as Shakira, then they would be implemented by the person who has them. The only information about investing that’s released to the masses is outdated.

6) Most people who recommend stocks do so because they have a financial inducement.

Really, just be real with yourself. Don't be so silly to really think that recommendations are just that. In the real investing world rarely are these stock or investing recommendations are not done free. Please not that most of the time the recommendations come after many, the inside guys, etc have already purchased at a lower price then what you would be getting in at.

7) Concentrate investing with a focus.

Don't go read and learn everything you can about every company or stock. You would be better off starting with a trend, or familiar with a few stocks and really research them down to the penny. Again, ALWAYS stick to your guns aka your investing plan, your investing style, and your investing strategy!

8) You need to put big money to see big profits.

Don't go quitting your day job on $5k of capital. It’s not that much money,
BUDDY! You would need a big bankroll to make decent money. This is true, but don't get the wrong idea as well. It's okay to start of with only $5k in starting a good solid investment focus. Balance is a the key, don't go to one extreme of not investing or the other extreme of quitting your day job to become a day trader on $5k of capital.

9) Don’t over due it on the diversifying or put away too much money into too many stocks.

If you do, you can expect to have a hard time getting good solid returns. If you start with a small amount of cash, you need to concentrate in one stock or few stocks to have the best result. Wait until you get some experience, some research, and before you go jumping into the deep end of the stock market.

10) Use stop losses.

Don’t ever lose more than we suggest 8% others might say 10% on any trade. If you use a stop-loss, you can guarantee that your downside is never less than 8% to 10%. This could save you in the event of a free fall. Also, a major key in this to, is to be discipline enough to keep putting in those stop losses even when the stock goes up. So say if your stock has gone up 15% well put a stop loss of a new 8% based on the 15% gain! This is discipline, but that's what it take in investing and in life!

Friday, October 20, 2006

Headwaters (HW)

Adding value to energy… and possibly your portfolio.
By eInvesting.com

Value investing involves finding a discrepancy between the price of a security and the value of the underlying company. Some people criticize value investing as boring or too prone to overlooking growth opportunities. But what happens if a solid, cash producing business was integrated with a research group intent on finding synergies to generate additional earnings from current operations, and also on finding important new breakthroughs to fuel growth further down in the company’s life?

That company would be Headwaters (ticker: HW), which has three distinct operating divisions - construction materials, coal, and alternative energy. Before I get into valuation, here is an overview of Headwaters’ various segments.

The materials unit currently makes up a majority of earnings and revenues, and involvement in that industry was management's decision to diversify the more risky and cyclical energy operations which offer most of the growth potential. While revenues have undoubtedly been raised by the housing construction boom, only about one-third of Headwaters sales in the area are for new housing construction, so any decrease in revenues and earnings because of fewer housing starts should be minimal. Wisely, there are already some synergies within the company because Headwaters converts used coal into concrete additives and synthetic stone. The use of fly ash-based concrete reduces atmospheric pollution, and as such is endorsed by the federal government and all fifty states for government contracts. Fly ash is also finding its way into mortars and stuccos, which Headwaters sells. Over the last few years, Headwaters has been making capital expenditures to expand its distribution network and establish itself in the field of building supplies. The conservative scenario is for Headwaters to keep capital expenditures in-line with revenues and earnings, so no marginal decrease in free cash flow rates should occur from the Materials division. Look for solid earnings and consistent growth.

The coal division is involved in coal combustion and by-product utilization (see above). Headwaters makes using coal inherently more efficient, and then also finds ways to add value to the byproducts after it has been used to produce energy. Coal remains a cheap, easy way to generate power and with the volatile and increasingly expensive, coal will become even more important in generating energy, both in America and around the globe. There are over 150 proposed coal-fired plants in the U.S. (not to mention hundreds more in other parts of the world), and environmental groups, while usually unable to stop construction, can at least get laws applied to make the coal “cleaner”. Headwaters is perfectly positioned for such a trend, offering both emissions control should coal be burned and is developing coal-to-liquids technology to allow for the creation of synthetic crude oil or natural gas from coal.

Considering that approximately 95% of America’s energy production capacity comes from coal, an amount significantly greater than can be found in the oil reserves of the Middle East, the uses for coal, and coal-to-liquids technology, seem abundant.

The final and most dynamic division is the Technology and Innovation unit, which does research in the alternative energy and heavy-oil areas. For everything you hear about the Canadian oil sands, regular refiners have enough problems handling and grade worse than light, sweet crude. As the remaining supplies of light, sweet crude are extracted, eventually more inferior grades will need to be refined… all the way to tar sands, which is proving the most difficult to handle. Headwaters’ (HC)3 Hydrocracking technology allows for heavy oil to be upgraded to more easily refined grades. Additionally, Hydrocracking can be used on low quality distillates remaining after the initial refining to turn them into higher-value petroleum products. A quick value-added calculation shows that it could easily be a multi-billion dollar addition to the economy, and if Headwaters' maintains its standard operating margin of 11% on it (not to say that it couldn't be higher, but I'm being conservative) it could double earnings just from capturing the upgrading market. If HC3 gained wider use as light oil blends decline and refiners increasingly switch to heavy oil, that could add even more to the bottom line. The high-side estimate for "upgrading" profits is about $600 million. Such a number does not include any profits to be made from applying Hydrocracking technology to the Canadian Tar Sands, as for now that is still too speculative to count on as a potential future revenue.

Headwaters is also involved in nanotechnology and fuel cell research, with numerous potential applications. Their proprietary NxCat nanotechnology is claimed to be the most efficient nanoagent created, outperforming today’s standard catalysts. More uses are being tested involving hydrogen peroxide production, LED displays, and carbon nanotubes. These potential breakthrough, while difficult to value directly, should be treated like having a free call option on an exciting and potentially lucrative future investment.

Current financial status and valuation: Headwaters has had a rough several months, with the rise in oil prices leading to a phasing out of tax credits benefiting some of Headwaters synthetic fuel catalysts. Headwaters has gone from $40 to near $20 back to $25 in the last few months as analysts have cut short term earnings estimates. Having become interested in this stock the first time it traded down through $25, I will admit to becoming bullish too soon and trying to “catch the falling knife”. The stock has begun to swing back up on some positive news, and buying now will mean that, although you missed the first 20% of the move, there could still be plenty of profit ahead.

For a company capitalized at just over $1 billion to have a trailing twelve month free cash flow of $150 million is amazing. HW does have about $500 million in debt, but I'm not too concerned about that because of the large cash flows which can be used to pay that down. They have cut total outstanding debt by 30% since the end of 2004, and the SEC filings say that Headwaters is prohibited from paying a dividend until it has no outstanding long-term liabilities. As long as Headwaters continues to pull in so much cash, their debt position should be no problem. Taking into all the above factors, if the company can eke out a moderate growth in the high single digit range over the next few years, a conservative exit multiple off that free cash flow makes HW undervalued by 35% - or about $35 per share. When you think of the huge potential gains down the road from the many growth areas the company has, its easy to see how this could be a $40 or even $50 stock sometime in the next year or two.

eInvesting.com is a free stock market simulator and forum. The author has no financial position in any stocks mentioned.

Thursday, October 19, 2006

Escala Group Inc. (ESCL)

Escala Group Inc. (ESCL)

ABOUT ESCALA GROUP
Escala Group is a global federation of leading companies in the collectibles market with operations in North America, Europe and Asia as well as on the Internet. The company operates through a number of subsidiaries that specialize in various sectors of the collectibles markets, and is comprised of three business areas: auctions, merchant/dealer operations and trading.

Escala Group's North American operations include Greg Manning Auctions division, Ivy & Manning Philatelic Auctions, Greg Manning Galleries, Greg Martin Auctions, Spectrum Numismatics, Teletrade, Nutmeg Stamp Sales, Superior Sports Auctions, Bowers and Merena Auctions, and Kingswood Coin Auctions, and H.R. Harmer. In Europe, the leading auction houses affiliated with the network are Auctentia Subastas (Afinsa Auctions) of Madrid, Spain, Corinphila Auktionen of Zurich, Switzerland, and the Koehler group of auction companies of Berlin and Wiesbaden, Germany. In Asia, Escala's auctions operations are conducted through John Bull Stamp Auctions, Ltd, the oldest philatelic auction house in Hong Kong.

The trading activities of Escala Group are conducted through A-Mark Precious Metals, one of the largest private sellers of bullion coins and bullion gold, silver and platinum to the wholesale marketplace.

Tuesday, October 17, 2006

Angeion Corp. (ANGN)

Angeion looks to be a buy for us here at 'Stocks Online'

These charts look good to me ANGN charts, but what do I know!

Also, it has some really good chart on stock charts check it out here!

One good thing that I really enjoyed and stuck out was the earning went from a loss of $(1.86)/share in 2001 down to a loss of $(.25)/share in 2005. The Angeion (ANGN) has turned around a profit with $.41/share reported. The Angeion (ANGN) has kept its 4 million shares outstanding stable from 2001 to present reports.

One thing that is a must for a lot of fundamentals is the free cash flow! Which with ANGN has been negative at $(1) million in 2003-2005, turned positive with $2 million reported as of recently. So that's a pretty impressive turnout that is turning a lot of head including ours here at stocks online! Also, with a $2.5 million in cash and $11.9 million in other current assets.

Seems to be an interesting look or at least one to be checking out and keeping an eye on it. Espcially after Angeion (ANGN) shares soared 80% on Monday after the tiny medical diagnostic systems maker swung to a fiscal third-quarter profit.

Wednesday, October 11, 2006

Technical vs. Fundamental Analysis

Technical vs. Fundamental Analysis
By Thomas Stone of statisticaltrading.com


The debate rages on. Which is better, technical analysis or fundamental analysis?

The question seems simple but it is deceptive. Underneath the question is an unspoken assumption about time horizons. Is the questioner an investor or a trader?

An investor is becoming part of something. The investor makes his choices based on a belief in the future. He desires to help make something successful. If he believes that apples will be in great demand next year he may invest in an orchard to grow apples for sale next year. During the year, while his apples are growing, he may ignore the day-to-day price changes of apples because his focus is on next year.

The trader doesn’t care to be part of anything other than the enterprise of making money. If he thinks orchards will increase in price next week, he’ll buy an orchard. He doesn’t care about orchards or apples. He’d buy a worm farm today if he thought he could turn a dime on it next week. He is very concerned about day-to-day price fluctuations since it is the past behavior of prices that make him expect the price to go up next week.

If the belief in the future value of apples is shaken then some of the orchard investors may decide that running an orchard isn’t the best choice. They abandon the business. Other investors see the cost of orchards dropping and, at some price point, believe that the now lower cost of orchards justifies the apple business given the reduced future price of apples. They start buying orchards.

This doesn’t happen all at once. Not everyone agrees with the amount that the price of apples will drop by. Because of this, different people see different price points as being good times to get back into the apple business.

The investor uses fundamental analysis to make his decisions, but what is the trader doing?

The trader is watching the patterns in the price of orchards and how frequently orchards are changing ownership as the prices go up or down. Eventually the pattern looks like a pattern that he has seen many times before and it usually occurs when prices have finished dropping and they are about to start escalating. Based on this, he decides to buy an orchard. He will hold that orchard until he thinks that he sees a pattern that suggests that the price of orchards will stop going up. He then sells the orchard. He has used technical analysis.

The trader’s technical analysis would be worthless without investors doing their fundamental analysis. Without the investors, there would be no patterns to watch for. It is the investors making their decisions based on fundamental analysis that creates the pricing patterns that the technical trader watches. The pricing pattern that indicates a bottoming in prices occurs when the price falls far enough to start attracting a large number of investors.

In the end, neither is better. Both technical and fundamental analysis help to create an efficient marketplace that can deliver goods to the consumer.

I refer to users of technical analysis as traders and users of fundamental analysis as investors. Their time horizons usually differ. Traders look to get in and out of a trade in hours, days, weeks, and sometimes months. Investors usually get in for months to years.

If you have a strong belief that something is going to happen and you are in the minority then you have an excellent opportunity to make a lot of money by investing in companies that stand to profit from that eventuality. Those profits won’t materialize until you are no longer in the minority. As more and more people start to share your belief, the prices of those companies will rise and you can profit handsomely. While you are waiting for others to start sharing your beliefs, the prices of those companies may go up and down. As long as your belief isn’t swayed you may bear those price swings secure in the knowledge of what is to come. You are an investor. On the other hand, if you’re wrong…

An example may be a belief that there will be water shortages resulting from global warming. Believing this, you may decide to invest part of your money in companies that build desalinization plants. You believe that, over the next 10-15 years, these companies’ products will see soaring demand. Secure in the belief that this will occur, you will not be terribly concerned if the price of one of those companies drops 5 percent next month. You believe that it will recover and then some. You are basing your decision on fundamental analysis.

The above is fundamental analysis on a macro economic scale. Bringing fundamental analysis to bear on a company-by-company basis is much more difficult. Numerous data points need to be entered, many of which are not available as hard data but rely on assumptions made by the person performing the fundamental analysis. One type of fundamental analysis called Discounted Cash Flow (DCF) is currently very popular. It involves formulas that take operating profit, depreciation, amortization, goodwill, capital expenditures, cash taxes, changes in working capital, and weighted average cost of capital, to arrive at a valuation for a company (see http://www.investopedia.com/articles/03/011403.asp for more detail).

Just collecting the data needed to perform the analysis for a single company can be a daunting task. Performing this kind of analysis on a large number of companies on a regular basis quickly becomes a full time job.

The trader on the other hand can use computers to scan for likely candidates for the pricing patterns that he uses. Within minutes a computer can download data on thousands of stocks and have the computer bring up relatively short lists of stocks that are potential candidates for trades.
A trader may also use technical analysis on the market as a whole to move money back and forth between an index fund and a money market fund. One simple way to do this is by using the market breadth.

Market breadth is simply a measure of the difference between the number of advancing issues and the number of declining issues on an exchange such as the NYSE. If 1200 stocks go up in price and 500 go down in price then the breadth is +700. We can calculate this number every day and then look for trends by calculating moving averages of these numbers. A good way to get long term directional movements is to analysis how two different moving averages changes relative to each other. The name for that practice is called Moving Average Convergence Divergence or MACD. If we apply MACD to the breadth using a 19-day and a 39-day moving average then we get a well-known indicator called the McClellan Summation Index (MSI).




Figure 1: MSI courtesy of StockCharts.com

If we look at the SP-500 for the same time frame



Figure 2: SP-500 courtesy of Stockcharts.com

If you had bought and sold an index fund based on the MSI peaks and valleys then you would have made the following trades (numbers and dates approximated)


Purchase date Cost Sales Date Price Profit/(Loss)
Late April ‘05 $1140 Late July ‘05 $1240 8.5%
Late Oct ‘05 $1180 Late Jan ‘06 $1280 8.5%
Late June ‘06 $1240 Late Sept ‘06 $1335 7.5%

You would have been in the market for 9 out of the last 17 months. While in the market you would have realized a 24.5% return plus the money market interest earned during the other 8 months, lets say 2.5%. That works out to a 19% annualized return (27*(12/17)).

How do you know when the MSI is at a peak or a valley? I use the MACD of the MSI with the averages being 30-day and 50-day. This smoothes out the action of the MSI and clearly shows the overall direction that it is moving in.



Figure 3: MACD of MSI courtesy of Stockcharts.com

The black line on the graph is a 9-day moving average of the red line. The red line is the MACD. The histogram shows the difference between the red and black line. The buy signal is when the MSI falls below –300 and the black line crosses up over the red line as it did in late Apr ’05, early Nov ’05, and late June ’06. The sell signal is when the MSI rises above +500 and the black line falls under the red line as it did in late July ’05, early Feb ’06, and late Sept ’06.

This indicator is not perfect at picking tops and bottoms. It is good at warning when the breadth of the market is no longer supportive of the direction of the market. The market usually changes direction shortly after that occurs. In the spring of ’06, this indicator was falling while the market indexes were advancing for an unusually long time. This meant that the number of stocks participating in the market move was dropping off. Fewer and fewer stocks were trading above their 40-day moving averages each week even as the SP-500 moved upward.

There are numerous technical indicators in use and there are many good books that discuss these indicators in depth. One such book is “New Trading Systems and Methods” by Perry J Kaufman. There are also computer programs that can be purchased that have many of these indictors built in such as TC2005 from Worden Bros (www.worden.com). There are also websites that have many of these indicators built in and some on-line brokers have charting packages containing some of the indicators.

The extreme in technical analysis is called Mechanical Trading. In mechanical trading a computer has extensively tested a set of indicators over numerous sets of historical data to arrive at an “ideal” set of indicators which the computer uses to issue buy and sell recommendations completely without any human intervention. My website, www.statisticaltrading.com, allows people to subscribe to computer generated buy and sell recommendations. Our computers have honed sets of technical indicators that have over 83% success rates with average holding times of 5-6 weeks. All recommendations come in the evening for execution at the next morning’s open; there is no day trading support on the site. We also offer a market timing service and a dividend investing service.

Monday, October 09, 2006

Getting Started: Learning the Market and Selecting Stocks

Getting Started: Learning the Market and Selecting Stocks

If you were going to spend several thousand dollars on a refrigerator or television, you would thoroughly research the market for those goods to find the product which best suited your needs. Investing is no different. Before buying into a company, you should be well-acquainted enough with it to give a short presentation. Knowing the basics of how a company operates, what it sells, how it makes money, how much money it makes, and what kind of growth the company is expected to experience are all crucial questions that any investor should be able to answer. Developing a better understanding of the stock market is a long, but hopefully rewarding, process. Immediately investing in stocks with real money, however, is equivalent to taking a test without being introduced to the material. Formerly called “paper trading”, beginning investors would normally spend several months tracking their stock picks without having real money on them. Thanks to technology, you can now find sites that automate (for free) the process of tracking price changes for you on the internet. Simulated investing is a risk-free way of beginning to understand market fluctuations and the forces driving them. Examining these trends will payoff in the future, as an increased understanding of the stock market can only help you on your path to building wealth. Once you become comfortable picking your own stocks, you can still continue to “paper trade” online, as it offers the opportunity to explore and experiment with other investing styles. Gordon Gekko, the famed villain in Wall Street played by Michael Douglas, said “Information is the most valuable commodity I know of”. Ignoring for a moment that the movie ended with indictments for insider trading, the statement is true: you will not regret being an informed and intelligent investor. The market is constantly changing, but by learning the ropes of investing you too can pull off a “One Up on Wall Street”.

Especialy thanks from einvesting.com Don't start investing alone. Check out einvesting.com today!

Thursday, October 05, 2006

GARP

GARP

GARP, or Growth At Reasonable Price. As the name implies, the focus is finding growing companies trading at reasonable prices. Quick measures of this include the PEG ratio (Price to Earnings to Growth) and Forward P/E. Although not a specific style, GARP is utilized by many investors because of its flexibility. The average, diversified portfolio will have many GARP-type stocks in it.

Wednesday, October 04, 2006

What is my risk tolerance and investing style

What is my risk tolerance? What is my investing style?

This question leads us to selecting individual investments. Consider your investment timetable for when you’ll need the money, recognizing that more conservative selections should be made the shorter the window. Everyone’s risk tolerance is different; while one person may feel comfortable with small-cap biotechs another may need a blue chip to feel equally sound.

Analyzing the risk to reward ratio here is a good first step. The more risk you take on, the more you should expect to get in return if your investment pays off. The inverse is also true: the more stable an investment, the less return one should expect. Government-backed I Bonds pay over 6%, but involve tying up money for years in order to fully benefit from them. While this gives you one target, the average return of the broader market indices is about 11% per year. There are two primary schools of thought about investing: growth and value.

Growth

Growth investing is a higher-risk strategy which focuses on finding smaller companies poised to rapidly grow earnings. Stocks here tend to be micro-caps or small-caps, and the occasional mid-cap (under $10 billion). In their younger lives, many of the well-established companies of today found themselves considered here (Think of Apple Computers (AAPL) or Starbucks (SBUX)). Growth companies can be found in many different sectors, although such companies often have similar traits. A growth company usually has a unique product or service to offer which can fundamentally change how business is done. When found early enough in their growth cycles, these companies have the potential to return enormous profits to investors.

Value

Value plays usually are found in larger companies, although the strategies used to find them can be applied to smaller corporations as well. Looking for value stocks is similar to looking for values in a store: find a good product at a price below what you would normally expect to pay. These bargains are often found in the form of companies which have been unfairly beaten down through overselling. Finding value stocks usually involves using a discounted cash flow model (DCF) to find a company’s intrinsic value. This is the form of investing advocated by Benjamin Graham, and popularized by Warren Buffett.

Questions to ask before investing

Questions to ask before investing

How much do I initially have to invest? How much can I afford to consistently add later?

Einstein described compounding as “The Eighth Wonder of the World” and for good reason. Being able to earn interest on your interest allows investments to increase exponentially faster than with simple interest. A one-time investment of $5000 earning 10% interest compounds to a total of over $54,000 after 25 years. Using simple interest, it would take over 95 years to reach the same amount. Naturally, the larger your initial investment and the more you can afford to add later on, the more you can expect to gain in returns.

Am I carrying any high-interest debt, such as on a credit card?

Before saving for future events, you should consider your present finances. Paying off any high-interest loans function as an “automatic” return. Writing a check to Visa to pay down your debt may not feel as satisfying as starting a nest egg, but by eliminating those 22% interest payments, you have effectively “made” a 22% return. Although you need not completely eliminate your debts, getting such payments into a reasonable area should be a more pressing priority.

This fiscal reckoning is also a good time to examine budgeting and expenditures. Look for unneeded or overpriced purchases, and consider the feasibility of paring them down and saving the extra money. Unused gym memberships, that $5 whipped mocha-hazelnut cappuccino, and extra cable channels all add up. The true cost of these and all other purchases involves understanding the “time value of money”, but for now it should suffice to say that $5 added to the previously mentioned investment account compounding 10% for 25 years turns into $54.17.

Technical vs. Fundamental Analysis

Technical vs. Fundamental Analysis
By Thomas Stone of statisticaltrading.com


The debate rages on. Which is better, technical analysis or fundamental analysis?

The question seems simple but it is deceptive. Underneath the question is an unspoken assumption about time horizons. Is the questioner an investor or a trader?

An investor is becoming part of something. The investor makes his choices based on a belief in the future. He desires to help make something successful. If he believes that apples will be in great demand next year he may invest in an orchard to grow apples for sale next year. During the year, while his apples are growing, he may ignore the day-to-day price changes of apples because his focus is on next year.

The trader doesn’t care to be part of anything other than the enterprise of making money. If he thinks orchards will increase in price next week, he’ll buy an orchard. He doesn’t care about orchards or apples. He’d buy a worm farm today if he thought he could turn a dime on it next week. He is very concerned about day-to-day price fluctuations since it is the past behavior of prices that make him expect the price to go up next week.

If the belief in the future value of apples is shaken then some of the orchard investors may decide that running an orchard isn’t the best choice. They abandon the business. Other investors see the cost of orchards dropping and, at some price point, believe that the now lower cost of orchards justifies the apple business given the reduced future price of apples. They start buying orchards.

This doesn’t happen all at once. Not everyone agrees with the amount that the price of apples will drop by. Because of this, different people see different price points as being good times to get back into the apple business.

The investor uses fundamental analysis to make his decisions, but what is the trader doing?

The trader is watching the patterns in the price of orchards and how frequently orchards are changing ownership as the prices go up or down. Eventually the pattern looks like a pattern that he has seen many times before and it usually occurs when prices have finished dropping and they are about to start escalating. Based on this, he decides to buy an orchard. He will hold that orchard until he thinks that he sees a pattern that suggests that the price of orchards will stop going up. He then sells the orchard. He has used technical analysis.

The trader’s technical analysis would be worthless without investors doing their fundamental analysis. Without the investors, there would be no patterns to watch for. It is the investors making their decisions based on fundamental analysis that creates the pricing patterns that the technical trader watches. The pricing pattern that indicates a bottoming in prices occurs when the price falls far enough to start attracting a large number of investors.

In the end, neither is better. Both technical and fundamental analysis help to create an efficient marketplace that can deliver goods to the consumer.

I refer to users of technical analysis as traders and users of fundamental analysis as investors. Their time horizons usually differ. Traders look to get in and out of a trade in hours, days, weeks, and sometimes months. Investors usually get in for months to years.

If you have a strong belief that something is going to happen and you are in the minority then you have an excellent opportunity to make a lot of money by investing in companies that stand to profit from that eventuality. Those profits won’t materialize until you are no longer in the minority. As more and more people start to share your belief, the prices of those companies will rise and you can profit handsomely. While you are waiting for others to start sharing your beliefs, the prices of those companies may go up and down. As long as your belief isn’t swayed you may bear those price swings secure in the knowledge of what is to come. You are an investor. On the other hand, if you’re wrong…

An example may be a belief that there will be water shortages resulting from global warming. Believing this, you may decide to invest part of your money in companies that build desalinization plants. You believe that, over the next 10-15 years, these companies’ products will see soaring demand. Secure in the belief that this will occur, you will not be terribly concerned if the price of one of those companies drops 5 percent next month. You believe that it will recover and then some. You are basing your decision on fundamental analysis.

The above is fundamental analysis on a macro economic scale. Bringing fundamental analysis to bear on a company-by-company basis is much more difficult. Numerous data points need to be entered, many of which are not available as hard data but rely on assumptions made by the person performing the fundamental analysis. One type of fundamental analysis called Discounted Cash Flow (DCF) is currently very popular. It involves formulas that take operating profit, depreciation, amortization, goodwill, capital expenditures, cash taxes, changes in working capital, and weighted average cost of capital, to arrive at a valuation for a company (see http://www.investopedia.com/articles/03/011403.asp for more detail).

Just collecting the data needed to perform the analysis for a single company can be a daunting task. Performing this kind of analysis on a large number of companies on a regular basis quickly becomes a full time job.

The trader on the other hand can use computers to scan for likely candidates for the pricing patterns that he uses. Within minutes a computer can download data on thousands of stocks and have the computer bring up relatively short lists of stocks that are potential candidates for trades.
A trader may also use technical analysis on the market as a whole to move money back and forth between an index fund and a money market fund. One simple way to do this is by using the market breadth.

Market breadth is simply a measure of the difference between the number of advancing issues and the number of declining issues on an exchange such as the NYSE. If 1200 stocks go up in price and 500 go down in price then the breadth is +700. We can calculate this number every day and then look for trends by calculating moving averages of these numbers. A good way to get long term directional movements is to analysis how two different moving averages changes relative to each other. The name for that practice is called Moving Average Convergence Divergence or MACD. If we apply MACD to the breadth using a 19-day and a 39-day moving average then we get a well-known indicator called the McClellan Summation Index (MSI).




Figure 1: MSI courtesy of StockCharts.com

If we look at the SP-500 for the same time frame



Figure 2: SP-500 courtesy of Stockcharts.com

If you had bought and sold an index fund based on the MSI peaks and valleys then you would have made the following trades (numbers and dates approximated)


Purchase date Cost Sales Date Price Profit/(Loss)
Late April ‘05 $1140 Late July ‘05 $1240 8.5%
Late Oct ‘05 $1180 Late Jan ‘06 $1280 8.5%
Late June ‘06 $1240 Late Sept ‘06 $1335 7.5%

You would have been in the market for 9 out of the last 17 months. While in the market you would have realized a 24.5% return plus the money market interest earned during the other 8 months, lets say 2.5%. That works out to a 19% annualized return (27*(12/17)).

How do you know when the MSI is at a peak or a valley? I use the MACD of the MSI with the averages being 30-day and 50-day. This smoothes out the action of the MSI and clearly shows the overall direction that it is moving in.



Figure 3: MACD of MSI courtesy of Stockcharts.com

The black line on the graph is a 9-day moving average of the red line. The red line is the MACD. The histogram shows the difference between the red and black line. The buy signal is when the MSI falls below –300 and the black line crosses up over the red line as it did in late Apr ’05, early Nov ’05, and late June ’06. The sell signal is when the MSI rises above +500 and the black line falls under the red line as it did in late July ’05, early Feb ’06, and late Sept ’06.

This indicator is not perfect at picking tops and bottoms. It is good at warning when the breadth of the market is no longer supportive of the direction of the market. The market usually changes direction shortly after that occurs. In the spring of ’06, this indicator was falling while the market indexes were advancing for an unusually long time. This meant that the number of stocks participating in the market move was dropping off. Fewer and fewer stocks were trading above their 40-day moving averages each week even as the SP-500 moved upward.

There are numerous technical indicators in use and there are many good books that discuss these indicators in depth. One such book is “New Trading Systems and Methods” by Perry J Kaufman. There are also computer programs that can be purchased that have many of these indictors built in such as TC2005 from Worden Bros (www.worden.com). There are also websites that have many of these indicators built in and some on-line brokers have charting packages containing some of the indicators.

The extreme in technical analysis is called Mechanical Trading. In mechanical trading a computer has extensively tested a set of indicators over numerous sets of historical data to arrive at an “ideal” set of indicators which the computer uses to issue buy and sell recommendations completely without any human intervention. My website, www.statisticaltrading.com, allows people to subscribe to computer generated buy and sell recommendations. Our computers have honed sets of technical indicators that have over 83% success rates with average holding times of 5-6 weeks. All recommendations come in the evening for execution at the next morning’s open; there is no day trading support on the site. We also offer a market timing service and a dividend investing service.

Monday, October 02, 2006

Before entering the world of investing

Before entering the world of investing, it is important to honestly analyze your present situation. Doing so will allow you to effectively manage your own money in a way which maximizes returns while limiting unwanted risk. Questions to consider include:

What is my investment goal? How much time do I have to attain this goal?

Methods of saving for a down payment on a house differ greatly from saving for retirement. The reason for this lies in the factoring of time. Over short periods of
a few years, individual companies and the stock market as a whole can experience dramatic fluctuations which in no way represent longer-term trends. Because of this possibility, a smaller percentage of your portfolio should be allocated into stocks as the time for cashing in your investments draws near. Conversely, the longer the time period you have to invest, the more aggressive your portfolio should seek higher returns.